Macroeconomic Fundamentals and External Sector Balances as Determinants of Exchange Rate Dynamics: Cross-Country Panel Evidence

Abstract

This study examines the macroeconomic and external sector determinants of exchange rate movements using panel data from six major economies—India, China, the United States, the United Kingdom, Australia, and South Africa for 19 years from 2005 to 2023 . These countries represent diverse economic structures, exchange rate regimes, and degrees of financial openness, allowing for a comparative assessment of how monetary conditions and Balance of Payments (BoP) dynamics influence foreign exchange prices.

The analysis employs a Fixed Effects (FE) panel regression framework to control for unobserved country-specific heterogeneity. Two empirical models are estimated. Model 1 investigates the impact of macroeconomic fundamentals—GDP, inflation, and interest rates—on exchange rates, while Model 2 incorporates key BoP components, including the current account, capital account, net financial account, errors and omissions, and the overall BoP surplus or deficit. Correlation and trend analyses complement the regression results by examining the direction and strength of relationships among variables.

The results indicate that monetary variables dominate exchange rate dynamics. Interest rates exert the strongest and most statistically significant influence on currency movements, consistent with interest parity and capital flow theories. Inflation is also significant, reflecting the interaction between price stability, monetary credibility, and investor expectations. GDP growth exhibits a weaker and negative effect, suggesting that growth in these economies is often import-intensive and associated with widening trade deficits. BoP variables show mixed effects: improvements in the overall BoP balance support currency appreciation, while large gross flows in the current account, capital account, and financial account are associated with depreciation and increased volatility. Correlation results confirm that interest rates are more strongly linked to exchange rates than external account components.

Overall, the findings suggest that exchange rate behavior is shaped primarily by monetary conditions and capital mobility rather than by real output or trade balances alone. The study highlights the importance of inflation control, credible monetary policy, and stable external financing for exchange rate stability and provides policy-relevant insights for managing foreign exchange risk in an increasingly integrated and volatile global financial environment.